How can one use mutual funds to save tax

As the financial year has just ended, we all might have rushed at the eleventh hour to save taxes. These options of saving taxes mostly pertain to deduction under section 80C.

Now a days the most common tax saving option under this scheme is the ELSS option, also known as Equity Linked Savings Scheme.

ELSS can be claimed as a part of 80C along with other deductions that form a part of this such as investment in PPF, payment of life insurance premium, contribution to National Pension Scheme (NPS which can be over and above 80C to the tune of 2 lakhs per annum) etc.

The problem with most of us is that we only remember saving taxes when the financial year is about to end i.e. when this tax weight hits us. To solve this problem, the best method that can be employed by us is to start planning from the beginning of the year itself. So the big question is how do we go about it?

Don’t worry. In this article, we will be discussing how investments in mutual funds can be used to save taxes. Meaning delving deep into the world of ELSS.

What is ELSS?

Popularly known as tax saving funds, ELSS qualifies as one of the tax saving vehicles under section 80C of the Income Tax Act, 1961.

The ELSS is a typical diversified equity mutual fund investment that comes not just with tax breaks but also requires a lock in period of three years. This is from the date of investment.

One important thing to note here is that ELSS is available also through the route of SIPs other than lump sums. We should remember that as each investment is for a period of three years, each deposit through an SIP will be locked in for three years from their respective investment date.

The other feature that ELSS possesses i.e. the lock in period of three years develops in us the habit of disciplined investing and having a long term vision in mind. Therefore, the twin benefits of tax savings and lock in period go hand in hand.

Most reputed AMCs like SBI mf provide ELSS funds

How Much Tax Can You Save

Well to answer the above mentioned question, we need to understand that section 80C of Income Tax Act qualifies as deduction from our income. Meaning the amount that we plan to invest in ELSS can be deducted from our salary before calculating taxes.

Let us understand this with the help of an example. Let’s say we are earning 12 lakhs per annum as gross total income. Therefore, as per tax slabs we are need to pay 30 percent taxes on income above 10 lakhs.

Therefore as per the above tax slab, the amount of taxes comes out to be INR 172,500.

Now let us take a situation wherein we make an investment of INR 1.5 lakhs in ELSS and therefore that qualifies as deduction under section 80C.

In this case, our taxable income comes out to be INR 10.5 lakhs, meaning the amount of taxes that we need to pay comes out to be INR 127,500. Therefore, on this basis we are saving a total of INR 45,000 on taxes.

Just look at the amount of tax savings we are having by making an investment of 1.5 lakhs. Means without generating any returns we are making a profit of INR 45,000. Also given the equity model under which an ELSS runs, we can also expect great returns if we hold on to our investments.

What are the Benefits of ELSS as Compared to Other Tax Saving Options?

Given the benefits discussed about ELSS, we can surely say that it can be used for capital appreciation. We can create wealth by linking the ELSS fund to our long term financial goal.

If we compare ELSS to other tax saving options such as PPF, NPS etc we find that ELSS beats these categories in various aspects.

Let us discuss to understand the differences:

In the above table we can see that ELSS funds have a great benefit when it comes to returns and lock in period as compared to other tax saving options.

The lock in period of PPF is 15 years with only partial withdrawal up to a certain year. When it comes to NPS, the withdrawal is done only during time of retirement.

Therefore, there is no comparison between ELSS and other categories of investments.

What are the Various Options Available Under ELSS Funds?

We may opt for either the dividend or the growth option when it comes to ELSS funds. The dividend option is suitable when we are looking for regular income whereas the growth option suits for long term growth of our investments.

However we should make a note that dividend options don’t provide us with assured returns. The performance of ELSS funds depends solely on the performance of equity markets.

Another important point relating to dividends that we should take care is that the dividend that we receive from mutual funds should not be thought of as that received from equity shares. In equity shares, the dividend is declared out of the profits by a company.

However, this is not in the case of mutual funds. Mutual funds declare dividends out of NAV. Meaning receiving dividends from mutual funds merely equal making redemption of units.

Note: In the budget of 2018, Finance Minister Mr. Arun Jaitley had declared that all dividends from an equity scheme will be subject to 10 percent dividend distribution tax. Hence it is recommended for investors to opt for the growth option as compared to dividend options in case of ELSS.

Best ELSS Funds to Invest for Long Term

Now that we know everything about ELSS funds, let us look at few of the best funds that we can invest in for long term.

Conclusion

Now that we have discussed various benefits that pertain to investments in ELSS funds, we should therefore plan to invest in these schemes throughout the year (either in lump sum or in SIPs) and not just restrict to investments during the tax savings season (popularly between January to March).

We should keep into account things such as past performance, age of the ELSS fund, the AUM size, the brand name of the AMC, expense ratio etc.